While it’s true that the core principles of the forex market may seem simple enough for many novice traders to grasp, the consideration of which trading method to engage in is often a much more nuanced issue as each strategy comes with its own unique principles, benefits and drawbacks.
For instance, some — such as scalping — are more rapid in nature and involve opening and closing positions within a single day, whereas others are more long-term in scope and make use of an entirely different mechanism in the hopes of turning a profit.
One such example of the latter is what’s known as ‘carry trading’, which this article aims to cover in a little more detail:
What is a Carry Trade?
Carry trading is the practice of borrowing or selling a financial instrument or asset with a low interest rate then using this capital to purchase an instrument with a much higher interest rate.
When done correctly, this strategy allows you to pay a low rate of interest on the first instrument, whilst collecting a higher rate of return on the instrument you purchased — even if its value remains static during that timeframe.
The difference between the two rates is commonly known as the ‘interest rate differential’ and is the key to making financial gains using this method.
Further reading: https://www.investopedia.com/carry-trade-definition-4682656
Carry Trading Explained
To use a straightforward example, suppose a trader borrows £20,000 with a 1% lending fee, i.e. he/she is obliged to pay £200 annually as a charge for the bank lending them the money.
Once in possession of these new funds, a carry trader may then look to buy a £20,000 bond or other type of financial security that yields him or her an interest rate of 5% — multiple times higher than the interest rate they owe on the first loan.
After a year, provided the value of the instrument doesn’t depreciate considerably, the trader will have profited from a 4% interest rate differential (a cool £800) without lifting a finger after the initial purchase, whilst also being able to pay off the 1% lending fee on the first instrument using the newly yielded funds alone.
Adding leverage into the mix can magnify this profit further, as a humble 5% return can become a 50% profit when using an account with a 1:10 leverage ratio!
Carry Trading with Currencies on the Forex Market
If you’re at all familiar with the world of forex trading, you’ll probably be aware that currencies are traded in what’s known as ‘currency pairs’ comprising a base and a counter currency — for example USD/JPY (with the US dollar as a base and Japanese yen as the counter) or EUR/GBP (the euro as the base and British pound as the counter).
When you open positions with currency pairs, you pay interest on the currency you sell — the counter currency — whilst simultaneously receiving interest on the currency you buy, or the base currency.
In fact, if you keep your position open for a period of days, weeks or even months, your broker will close your position at the end of each trading day and automatically re-open it when the market starts up again, whilst either debiting or crediting you the interest rate differential between the two currencies as of the previous night’s closing values. It’s through this mechanism that forex traders are able to profit from carry trading principles on the foreign exchange market.
Perhaps unsurprisingly, AUD/JPY is a popular choice for currency carry trades of this nature, since the Australian dollar has historically yielded higher interest rates than most major currencies, while the yen is typically known for being a low interest, safe-haven asset.
Further reading: https://www.fxcm.com/uk/insights/what-is-a-currency-carry-trade/
When are Carry Trade Strategies Most Effective?
As with any trade centred around purchasing currencies, carry trades are most likely to prove profitable when conducted with base currencies that have an optimistic sentiment surrounding them — at least in the long term, if not right in the present.
This is because if a country’s economy seems to be doing well, its central bank will likely have to raise interest rates sooner or later in order to curb unwanted inflation As a result, the interest rate differential between the two currencies is likely to increase, which will translate to higher profits for the carry trader.
Conversely, when a nation’s economy seems to be stalling or otherwise struggling, fewer traders will be willing to invest in its respective currency; this risk-averse sentiment often leads to interest rates being lowered over time (with a view to enticing more investment), which will hamper the returns on any carry trade being conducted.
In short, when the forex market is unsure, it tends to put its faith (and therefore capital) in safe-haven, low-interest currencies and assets. Carry traders, though, look for the opposite situation when choosing their base currencies; namely, riskier currencies that have a lot of investor momentum heading in their direction, as these are ideal for capitalising off interest rate differentials when twinned with low-interest assets.
Further reading: https://www.ig.com/en-ch/trading-strategies/what-is-the-best-currency-carry-trading-strategy--191122
What are the Main Risks to Consider When Carry Trading?
The most obvious and immediate risk faced by carry traders is simply the uncertain and precarious nature of global exchange rates, especially when investors are keeping positions open for a longer than average period.
Though turning a profit may seem guaranteed if you’ve spent a lot of time researching your instruments beforehand, you could still stand to lose lots of money if your higher-yield currency were to fall dramatically in relation to the counter due to some unforeseen event.
What’s more, many carry traders choose to employ high amounts of leverage in their transactions, which leaves them open to the risk of a small movement in the markets snowballing into a substantial loss.
For this reason — as with all forex activity — robust risk management is a must when conducting carry trades.
Further reading: https://www.dailyfx.com/education/why-trade-forex/currency-carry-trade.html
Use at your own risk disclaimer
The content contained herein does not construe any form of advice and the user must not take this as such. We do not accept any liability for the direct or indirect usage of the content held in this article. We strongly advise that you obtain independent financial, legal and tax advice before proceeding with any currency or spot metals trades.
